As Congress works to finalize the proposed $3.5 trillion Build Back Better Act (“Infrastructure Bill”), the Senate Finance Committee and the House Committee on Ways and Means are discussing many changes to current tax laws that would have significant impact on real estate professionals and those developing real estate. These changes are intended to bridge the gap between the anticipated tax base and what Congress believes will be required to fund the Infrastructure Framework passed by the Senate earlier this year. The changes proposed are widespread; however, three specific changes that have been widely discussed will have material impact on the real estate industry. Specifically, Congress has considered many proposals related to taxing carried interest, including taxing carried interest as ordinary income. Likewise, Congress is considering eliminating or making other modifications to like-kind exchanges. And finally, Congress has discussed eliminating stepped-up basis for inherited assets. While this is a topic generally rife with political undertones and commentary, the intent of this article is not to take a political position or advocate for a political party; rather, we intend to discuss the implications each proposal policy will have on the real estate industry broadly.
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Carried Interest
As those in the real estate industry are keenly aware, carried interest is the term often used to describe the “interest” of equity holders in real estate joint ventures. When a sale or other capital event occurs, the general partner, managing member, and others are commonly paid a carried interest. Both income generated through a carried interest and profits directly from the sale of real property are taxed as capital gains, which are currently taxed at a maximum rate of 20%. The congressional committees have suggested taxing carried interests as ordinary income, which would subject them to an increased tax burden climbing to a potential 37%. Additionally, Congress has proposed taxing carried interests annually, based on perceived value, regardless of whether a capital event has occurred.
Taxing these interests as income, or worse yet, before a capital event where any value has been created, fails to recognize that the risk profile of a real estate investment is much different than wage income from providing a service. Real estate investors often risk their own capital, sign personal guarantees and, at the end of the day, are improving property with the goal of increasing its value. That goal is not a certainty, and many investors may be unwilling to put their own money or assets on the line if the tax code is changed to ignore the value of those risks.
Each proposal would undoubtedly stifle investment and, when there is less incentive to invest, higher risk projects where success is far from certain will be the first to go. Often-times, those projects are in typically underserved markets, food deserts, or otherwise involve complicated redevelopment.
Like-Kind Exchanges
The proposed tax changes would limit or possibly eliminate like-kind exchanges, commonly referred to as “1031 Exchanges” after Section 1031 of the Internal Revenue Code. Like-kind exchanges have been used by real estate investors since 921. Generally, like-kind exchanges allow a property owner to defer taxes on the sale of real estate if that person or entity acquires a “like-kind” property within 180 days. As an oversimplified example, if a successful family bakery needed to move into a new, larger space, they could sell their current location, and use the proceeds to buy a new bakery and defer the taxes from the sale until they eventually sold the larger bakery. Likewise, a developer could improve an apartment complex in an underserved community, and then use the proceeds from that sale to start work on another like-kind project. Eliminating this structure would make it much harder for the bakery to grow and certainly change the investment criteria for many family-run businesses and others that are considering the sale of real estate assets.
Aside from the obvious direct implications on real estate investors and small businesses, this change would also have a ripple effect on the industries that serve 1031 investors or facilitate line-kind exchanges. One estimate pegs the number of jobs that support 1031 exchanges as more than 580,000, and also notes that 1031 exchanges generate $27.5 billion of labor income each year. 1031 exchanges also increase property values and enable the efficient deployment of capital for reinvestment in development projects.
Stepped-Up Tax Basis
Finally, Congress is discussing eliminating the concept of stepped-up tax basis for inherited assets. Removing stepped-up basis would directly affect many individuals and small, family businesses. As the tax code is currently written, when a person or entity sells an inherited asset, they pay capital gains taxes on the difference between the current value of the asset and the value from when they inherited the property. The new proposal would require that the person selling the asset pay taxes not only on the increase in value while they have owned the asset, but also on the increase in value from when their ancestor owned the property. According to a recent survey, 70% of owner/developer businesses are family owned. 86% of those family-owned businesses intend to pass the company down to their heirs, but 77% of them said their companies do not have the cash flow needed to pay this tax bill. These family businesses will be directly affected by this change in policy.
As the Senate Finance Committee and the House Committee on Ways and Means seek to find ways to finance the Infrastructure Framework, tax increases are likely unavoidable. Certain options being considered, including the tax treatment of carried interest, limitation of like-kind exchanges, and elimination of stepped-up basis, directly affect the real estate industry.
If you, your family, or your business would be impacted by these policy decisions, reach out to your representatives in both the House of Representatives and the Senate to discuss these proposals with them.
Jason F. Wood is the Arizona chair of Quarles & Brady‘s Real Estate Practice Group. Thomas J. Whitten is an associate in Quarles & Brady’s Phoenix Real Estate Group.
